Has Anybody Taken a <I>Really</I> Close Look at Amazon's Latest Quarter?

Hedge fund manager Jeff Matthews did. Wait'll you see his conclusions.
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Oh, no, not another story bashing Amazon.com (AMZN) - Get Report! We already know that sales growth is slowing, revenue per customer is down and marketing costs are rising. (Not a healthy combo.) We also know the company is expanding into a broad-based, nonbooks retailer (lots of competition) and that it's spending heavily on bricks-and-mortar warehousing infrastructure (so much for the online advantage). Then there's the uncertainty about Amazon's expansion away from books, where the lack of selection makes it just another retailer. What else could possibly be said?

Read the following, a piece written exclusively for this column by hedge fund manager Jeff Matthews, who holds puts on Amazon.com -- a bet that its stock will fall -- and you'll see why any Amazon investor should really be taking a closer look at the most recent quarter's numbers. Jeff runs Ram Partners in Greenwich, Conn. and is one of this column's longtime and most thoughtful sources. Remember his call here a year and a half ago about problems at Compaq (CPQ) ? His Amazon comments are just as good. Rather than try to work a column around what he says, I thought I'd let him say it himself. He calls it "A River Runs Dry." Enjoy. HG

.

A funny thing happened on the way to the New Paradigm. Unnoticed by the press, and unremarked on by Wall Street analysts, is the disquieting implication of the recent earnings report from the granddaddy of the Internet -- Amazon.com.

A close look at Amazon's June quarter numbers reveals that the company may be (as a friend of mine likes to say about these things) "hitting the trees with no flaps down."

No, I'm not recycling the old news that the company lost 26 cents on each revenue dollar and that cash flow was negative; Amazon is not a profit story. And the fact that Amazon's customer acquisition costs are going up while its customers' average purchase is going down has already been mentioned in the financial press.

My focus is on growth, which is what Internet investors (including myself) pay for. And what is remarkable is that Amazon barely grew from the March quarter to the June quarter. Sequential sales growth was only 7% -- down from last year's 33% growth in the same time period and the slowest sequential growth ever for the company.

Give the company credit for masking the decline by blaming what Wall Street analysts said was "normal seasonality" in retail sales generally and Internet sales in particular (people spend more time outdoors in the spring, goes the thinking). But Amazon's deceleration is not normal, it is not seasonal and it is worse than it looks because half the growth came from international sales and from new initiatives. The core U.S. business approached stagnation.

Here are the numbers: We know international sales made up 23.9% of Amazon's revenue in the June quarter, and 22% in the March quarter. Backing out those international sales, Amazon's U.S. business grew only 4.5% sequentially. One more thing: the company started up its auction business in the month of March. I'll guesstimate that in the June quarter, Amazon's auction site did no more than a few percent of the $50 million

eBay

(EBAY) - Get Report

did in their June quarter -- call it $2 million. Subtracting both the international business and the auction guesstimate gives us an "apples-to-apples" comparison of what Amazon's U.S. book, music and video business did from the first to the second quarter of 1999: 3.4% growth. Repeat: 3.4% growth.

This means Amazon barely outperformed

Barnes & Noble's

(BKS) - Get Report

"dinosaur" bricks-and-mortar superstore business, which grew 2% from first to second quarter. Barnes & Noble's Internet business, by the way, grew 21% during the same period -- off a smaller sales base, but still it grew six times faster and about the same in dollars as did Amazon's U.S. business.

Now, in order to confirm that Amazon's slowdown went beyond "normal seasonality" in overall retail sales, it was necessary to find a retailer that uses the calendar fiscal year, as Amazon does. (Amazon is on a calendar fiscal year, so its first and second quarters end in March and June, while Barnes & Nobles is on a "retail" fiscal year ending in January, so its first and second quarters end in April and July.) So I found a retailer that is about as generic as you can get.

I found

Sears

(S) - Get Report

.

And Sears' retail sales grew 15% from its March quarter to its June quarter. You can't blame "seasonality" for crimping Amazon's sales. Lowly Sears beat Amazon hands down. I then checked

Onsale

(ONSL)

, one of the first Internet e-tailing sites, to see if sales slowed in their June quarter because "people spend more time outdoors in the spring." Onsale grew 20%. (And Onsale is no great shakes businesswise -- in fact, it recently preannounced that September quarter revenue would be far lower than published estimates.)

A reasonable person could conclude that Amazon has sprung a leak. This swift maturation of what was expected to be a long-enduring business model has tremendous ramifications -- not just for the momentum investors who own Amazon stock but for the dozens of copycat companies that have come public; the hundreds that have received venture funding; the thousands that are now starting up in the hopes of becoming "the next Amazon."

A hasty judgment? Perhaps. But I am no Luddite. I have been an Amazon customer for several years. I have invested privately in Internet start-ups. I was short Barnes & Noble stock when, in my opinion, "they just didn't get it." I do admit to being a "value-oriented investor" with little taste for multiples above 10 times sales (and having an insignificant put position in Amazon's shares and an outright short position in Onsale, more than offset by other Internet-related long positions). But by no means have I ever doubted the power of a business model with negligible fixed costs and instant worldwide market potential via a few mouse clicks. I just thought it would last longer than this.

Defenders of the faith will scoff at the notion that Amazon is headed for a Sears-type old age this early in its life. A mere one or two quarter's worth of sales reverting to the mean has not scared anybody, to judge by the stock's recent uptrend. Besides, not one Wall Street analyst has highlighted the slowdown, or noted its severity or questioned its meaning (a simple back-of-the-envelope calculation would reveal it, but nobody uses envelopes any more).

Yet there is a deeper manifestation of the problem with Amazon, and it goes to the heart of the matter. Now that Amazon is ramping up its own distribution centers (rather than outsourcing distribution), the company's fixed asset base is exploding. And as it explodes (up 10-fold in one year), the company becomes less efficient at turning its invested dollars into sales.

Last year, Amazon's second-quarter sales were $116 million, or eight times its fixed assets (computers, office space, telephones, desks, etc.). That was a great ratio, because it meant Amazon was much more efficient than most retailers at generating sales from a small investment in overhead. Sears, by comparison, turned fixed assets only 1.4 times in the same period. This year, however, Amazon's fixed asset turnover dropped to two times. (And I have not included the large goodwill they now carry as a result of recent acquisitions, which would drop the ratio below one.)

If Amazon is only turning its fixed asset base about as fast as Sears -- the company long considered the worst large retailer on the Big Board -- and if Amazon's sales growth is looking more like a bricks-and-mortar chain than an e-tailer, and if it is losing 25 cents on each dollar of those sales, how will Amazon ever --

ever

-- make a profit?

Amazon's business model is broken, that much seems clear from the numbers at hand. How much time does management have to fix the model? Well, Amazon is unique in many ways besides the size of its Web site, the size of its book inventory and the size of its huge new distribution centers. It is unique among Internet companies in the size of its debt. Amazon has $1.45 billion of debt, and $1.1 billion of cash. The debt was sold when Amazon stock was going up, along with the company's revenue. Now, the cash is being spent quickly -- at least $100 million per quarter so far this year -- yet the sales growth is slowing.

Unless the trends change quickly, Amazon may well become merely a slow growth company losing 20 cents or more on the dollar, with a lot of debt to repay and continuing negative cash flow.

Give Amazon management credit for keeping our eyes on the next big thing rather than the numbers: Amazon auctions (disappointing thus far), Amazon toys (still in its, er, infancy), Amazon consumer electronics (too new to call). Besides, Wall Street is pointing to a strong Christmas season as a reason to own the stock and others like it. But a broken model is a broken model, whether it's Christmas, spring, summer or fall; whether the model is losing money by selling

Tom Clancy

novels or

3Com

(COMS)

Palm Pilots. And the numbers show that Amazon's core business of books, music and videos has already matured, right before our eyes.

In "Internet time."

Amazon declined comment.

Jeff Matthews runs Ram Partners, a private hedge fund in Greenwich, Conn. At the time of publication, his fund was short Amazon.com and Onsale, although positions may change at any time.

Herb Greenberg writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, though he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback at

herb@thestreet.com. Greenberg also writes a monthly column for Fortune.

Mark Martinez assisted with the reporting of this column.